How Many Hedge Funds Will Die Next Year? (Answer: A Ton)

For those who keep hearing about hedge funds but aren't quite sure what they
are: Think mutual fund with no rules. A hedge fund is an investment company
that can do pretty much anything, from shorting currencies to betting on biotech
takeovers to writing credit default swaps.

This kind of freedom, as you can imagine, requires a fair degree of creativity,
if not genius, on the part of fund managers. And therein lies the problem.
As the concept has gotten popular the number of hedge funds and the money they
manage have soared. There are now 11,000 of them running about $3 trillion.

But have we produced 6,000 new super-genius money managers to handle all the
extra money? Of course not. As in any other field, the sudden popularity of
a concept just sucks in mediocre people from other niches. The result: Massive
amounts of hedge fund money chasing pretty much everything, with an emphasis
on what went up last year. The momentum trades are insanely crowded, and hedge
fund returns in the aggregate have failed to exceed those of, say, an S&P
500 ETF for the past six years.

(Bloomberg) - Earlier this week, Greg Zuckerman of the Wall Street Journal
pointed out one of the great mysteries of today's investment landscape: Despite
underperforming by a substantial margin, hedge funds keep attracting more
investors and assets under management. It is almost as if (to borrow the
headline on Zuckerman's article), "Hedge Funds Keep Winning Despite Losing." He
wrote:

Hedge funds aren't just underperforming against the S&P 500 and other
stock indexes. They're also losing out to low-cost "balanced" mutual funds
that hold a mix of stocks and more-conservative investments, just like many
hedge funds, suggesting their poor performance can't be blamed on a hedged
approach.

Consider the data: According to HFR, a firm that created indexes to track
hedge-fund performance, the average hedge fund gained a mere 3 percent in
2014 versus an 11 percent rise in the Standard & Poor's 500 Index. That's
hardly worth paying a hedge fund outsized 2 percent management fees plus
a 20 percent cut of the profits.

Simon Lack, in his book "Hedge Fund Mirage," describes why indexes such
as those developed by HFR significantly overstate returns. That 3 percent
gain last year, or about 7 percent annually since 2009, likely excludes funds
that underperform. Funds don't have any obligation to report their performance
-- it's strictly voluntary. What we see in these indexes is an absence of
poor performers that, were they included, might give a more accurate picture
of the industry's results. And that's before we get to the issue of survivorship
bias -- funds that have gone belly up and closed due to their dismal results
are missing from the index as well.

Perhaps you believe that the S&P 500 is an inappropriate benchmark.
Consider a simple 60/40 portfolio of stocks and bonds. According to research
from the Vanguard Group, that simple portfolio beat the returns of not only
the hedge-fund industry as a whole, but almost all of the individual funds
except for the outlying performance stars. And this 60/40 portfolio did it
while charging fees of just 0.24 percent. The balanced fund beat the main
Bloomberg hedge-fund index in six of the last seven calendar years, according
to data compiled by Bloomberg. No wonder there is so much angst in Greenwich,
Connecticut, home to many hedge funds.

This would be nothing more than an interesting bit of trivia if not for the
fact that so many hedge funds use leverage. That is, they borrow money and
toss it at whatever they're chasing in order to magnify their returns. So when
it doesn't work they lose far more than they would have otherwise.

And now, with everything from energy junk bonds to emerging market currencies
to blue chip equities imploding, the carnage in the hedge fund space can't
help but be epic. The question is how systemically dangerous the death of,
say 5,000 of these funds will be. To which the likely answer is: Extremely.

John Rubino edits DollarCollapse.com and has authored or co-authored five
books, including The Money Bubble: What To Do Before It Pops, Clean
Money: Picking Winners in the Green Tech Boom, The Collapse of the Dollar
and How to Profit From It, and How to Profit from the Coming Real Estate
Bust. After earning a Finance MBA from New York University, he spent the
1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst.
During the 1990s he was a featured columnist with TheStreet.com and a frequent
contributor to Individual Investor, Online Investor, and Consumers Digest,
among many other publications. He now writes for CFA Magazine.